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RMI 3011 Exam 1 Study Guide Chapter 1 Risk in Our Society Risk defined as uncertainty concerning the occurrence of a loss Example the risk of being killed in a car accident is present because uncertainty is present Loss exposure is any situation or circumstance in which a loss is possible regardless of whether a loss occurs Potential loss Example manufacturing plants that may be damaged by an earthquake or flood Objective risk also called degree of risk defined as the relative variation of actual loss from expected loss Example 1 000 houses are insured and on average 1 or 100 houses burn each year In some years as few as 90 houses burn in other years as many as 110 houses may burn Thus there is a variation of 10 houses from the expected number of 100 or a variation of 10 Objective risk declines as the number of exposures increases o Objective risk varies inversely with the square root of the number of cases under observation Since objective risk can be measured it is an extremely useful concept for an insurer or a corporate risk manager As the number of exposures increases an insurer can predict its future loss experience more accurately because it can rely on the law of large numbers o The law of large numbers states that as the number of exposure units increases the more closely the actual loss experience will approach the expected loss experience Example as the number of homes under observation increases the greater the degree of accuracy in predicting the proportion of homes that will burn Subjective Risk defined as uncertainty based on a person s mental condition or state of mind Example a customer who was drinking heavily in a bar may foolishly attempt to drive home The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driving The mental uncertainty is called subjective risk High subjective risk often results in conservative and prudent behavior Low subjective risk may result in less conservative behavior Chance of loss defined as the probability that an event will occur like risk probability has both objective and subjective aspects Objective Probability refers to the long run relative frequency of an event based on the assumptions of an infinite number of observations and no change in the underlying conditions o Determined in 2 ways 1 First they can be determined by deductive reasoning These probabilities are called a priori probabilities o Example the probability of getting a head from a coin toss is because there are two sides and only on is head Likewise the probability of rolling a 6 with a single die is 1 6 since there are six sides and only one side has six dots on it 2 Second objective probabilities can be determined by inductive reasoning Example the probability that a person age 21 will die before age 26 cannot be logically deduced However by a careful analysis of past mortality experience life insurers can estimate the probability of death and sell a five year term life insurance policy issued at age 21 Subjective Probability is the individual s personal estimate of the change of loss o Example people who buy a lottery ticket on their birthday may believe it is their lucky day and overestimate the small change of winning o A wide variety of factors can influence subjective probability including a person s age gender intelligence education and the use of alcohol Chance of loss can be distinguished from objective risk o The chance of loss may be identical for two different groups but objective risk may be quite different Example assume that a property insurer has 10 000 homes insured in Los Angeles and 10 000 homes insured in Philadelphia and that the chance of a fire in each city is 1 Thus on average 100 home should burn annually in each city However if the annual variation in losses ranges from 75 to 125 in Philadelphia but only from 90 to 110 in Los Angeles objective risk is greater in Philadelphia even though the chance of loss in both cities is the same Peril and Hazard Peril is defined as the cause of loss o Ex if your house burns down because of a fire the fire is the peril Hazard is a condition that creates or increases the frequency or severity of loss o Four major types of hazard Physical hazard a physical condition that increases the frequency or severity of loss Ex icy roads increase the chance of an accident Moral hazard is dishonesty or character defects in an individual that increase the frequency or severity of loss Ex faking an accident to collect from an insurer Difficult to control and makes premiums higher for everyone o Insurers attempt to control this hazard by careful underwriting of applicants for insurance and by various policy provisions Attitudinal hazard morale hazard is carelessness or indifference to a loss which increases the frequency or severity of a loss Ex leaving car keys in an unlocked car which increases the chance of theft Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses Ex adverse jury verdicts or large damage awards in liability lawsuits Classification of Risk Risk is classified into several distinct classes the most important are the following 1 Pure and speculative risk Pure risk is defined as a situation in which there are only the possibilities of loss or no loss The only possible outcomes are adverse loss and neutral no loss o Ex premature death job related accidents Speculative risk is defined as a situation in which either profit or loss is possible Ex if you purchase 100 shares of common stock you would profit if the price of the stock increases but would lose if the price declines Difference between pure and speculative risks First private insurers typically insure only pure risks With certain exceptions private insurers generally do not insure speculative risks and other techniques for dealing with speculative risk must be used Second the law of large numbers can be applied more easily to pure risks than to speculative risks o It s difficult to apply the law to speculative risks to predict future loss experience An exception is the speculative risk of gambling Finally society may benefit from a speculative risk even though a loss occurs but it is harmed if a pure risk is present and a loss occurs o Ex a firm may develop new technology for producing inexpensive computers As a result some competitors may be forced into bankruptcy Despite the bankruptcy society benefits


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FSU RMI 3011 - Chapter 1: Risk in Our Society

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Risk

Risk

26 pages

Exam #2

Exam #2

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Exam #2

Exam #2

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Exam #3

Exam #3

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Exam #3

Exam #3

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Exam 1

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EXAM 1

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Exam 1

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Test 2

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Test 1

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Chapter 1

Chapter 1

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Test 2

Test 2

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Test 1

Test 1

5 pages

TEST 2

TEST 2

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Chapter 1

Chapter 1

56 pages

Notes

Notes

18 pages

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